Universal Orbit
A Schematic of Decision Making: Corporate Finance and Capital Markets
The Uncorrelated
052615
Once deemed uncorrelated, sovereign energy policies combine infrastructure development with corporate capital investment accounting for both scalability of renewable sources over the next 25 years and commodity strip pricing in the short-term. Reflecting continued private investment in public policy, simple audit of global multinational corporate profiles features integrated wind and solar operations—a dedication of business segments operations within industrial portfolios including oil and gas.
Applying commonly correlated expectations, lower relative oil and gas prices increase the profitability of companies in capital intensive and consumer sectors. The introduction of economic and growth oriented proxies demonstrate this shared rationalization, seemingly unrelated to the corporate innovations embedded in emerging technologies and independent of industry verticals rooted in renewable energy policies. Certainly from a long view, illustrated by a binary 10-year pairing of ETF benchmarks USO - United States Oil Fund LP and PBW - PowerShares WilderHill Clean Energy Portfolio, no meaningful divergence in total return performance is evident:
Foremost to consider when examining the drivers of valuation is reconciliation of global oil supply elasticity with the inelasticity of renewables demand represented by sovereign/federal/state/municipal energy mandates, specifically as it relates to potential limitations on renewables investment in a low-cost energy environment. Issues of elasticity are academically well-defined with conventional wisdom suggesting the swing producer status sought by US shale exploration and production companies in the present geostrategic price-volume battle diminishes marginal demand requisite for stability and growth of renewables capital investment. After all, even at historically high prices of oil and gas, past efforts advocating a higher per unit carbon price to levelize the cost of energy have proven to be a tactically weak strategy easily forgone during periods of economic stress.
Fortunately baseline policies are defined and measurable, mathematically comprising one energy equation. Protocols established by the US Department of Energy provide period projections in a contextual framework along with percentage parameter allocations. In the end, sources of electricity generation and uses of energy consumption are two sides of the same coin. Accordingly, the US DOE Energy Information Administration’s Annual Energy Outlook 2015 forecasts electricity generation by source into 2040:
Natural gas 31% (+15% from 2013, +94% from 2000), Renewables 18% (+39%, +100%), Nuclear 16% (-16%, -20%), Coal 34% (-13%, -35%) and Petroleum 1% (unchanged, -67%).
On the demand-side, the AEO 2015 details energy consumption:
Natural gas 29% (+7% from 2013, +26% from 1990), Renewables 10% (+25%, +43%), Liquid biofuels 1% (unch., +100%), Nuclear 8% (unch., +14%), Coal 18% (unch., -22%) and Petroleum 33% (-8%, -18%).
Renewables represent one-third of new generation capacity led by growth in wind (40% of all renewable generation, 2013-2040) and solar (+6.8% average annual growth rate). Spurred by federal investment and production tax credits in addition to state renewables portfolio standards, capital investment runs in tandem with populist if not scientifically-based initiatives and against looming incentive expirations. Natural gas serves as marginal supply-side player per kilowatt hour, demand-side driver of reduced cost inputs and merits a plurality of end-use applications from industrials to transportation. Based on AEO 2015 estimates, US carbon emissions in 2040 remain below 2005 levels primarily due to the prevalence of domestic natural gas resources despite sustained increases in domestic unconventional oil production.
Taking a global view, the International Energy Agency details projected portfolio power generation capacity composition in this infographic:
Against the backdrop of global population growth (+1.1% compound annual growth rate) and with global energy demand rising by 37%, the IEA World Energy Outlook 2014 projects a fourfold increase of wind (utility scale) and solar (distributed generation) assets in its New Policies Scenario followed by increased demand for natural gas (+50%), oil (+16%) and coal (+15%). WEO-2014 estimates worldwide demand for oil rising to 104 million barrels per day in 2040 on a doubling of automobile volume demand predominantly in developing countries. Both opportunity and challenge for the energy complex, disparities between mature and developing countries improve and persist evident notably in Africa where one billion people gain access to electricity by 2040 though still leaving 500 million people without.
Solving simultaneous electricity capacity supply-side and energy consumption demand-side equations borne by sovereign policies requires consideration of the differentiated growth rates across economic sectors, geography and asset classes. Recent boom-to-bust (then recovery) cycles in Energy-Oil & Gas and Alternative Energy reveal the often fragility of a defined investment thesis. From a capital market perspective, Alpha generation demands the application of analysis apart from institutionally defined sector research, assigned performance benchmarks and traditional portfolio construction.
Based on the premise of a one energy equation, refined peer group analytics and valuation techniques present an opportunity to utilize benchmark Exchange-Traded Funds as complete composite Energy sector and subsector proxies. The comparative 10-year chart below incorporates XLE - Energy Select Sector SPDR Fund, UNG - United States Natural Gas Fund LP, KOL - Market Vectors Coal ETF, NLR - Market Vectors Uranium & Nuclear Energy ETF and PBW - PowerShares WilderHill Clean Energy Portfolio as component members:
Efforts to exploit the current debate within the equation reveal an overriding theme of trend capacity growth rates and rotation above or below macro, sector, policy and peer provider levels. Thematically demonstrating Energy ETF subsector proxy parameters, XLE composite deconstruction is characterized by sustainability (exploration and production), volume (oil field services), infrastructure (pipelines), consumer (refining) and M&A (distressed) providing for benchmark portfolio analysis and component member screening. In our hypercompetitive global economic and investment environment, simply contesting a mere 1-2% market share of marginal oil supply may impact corporate valuations by half or greater. Also distinct are the dramatic growth rates of wind and solar, equally sensitive to economic change and externalities in bull and bear markets. Displaying the effects and volatility associated with the marginal supply of energy among unconventional oil, wind and solar companies, represented below are Energy subsector proxies FRAK - Market Vectors Unconventional Oil & Gas ETF, TAN - Guggenheim Solar ETF and FAN - First Trust Global Wind Energy ETF:
Comparative performance (3-year TAN +179% > FAN +101% > FRAK 9%) is perhaps counterintuitive as conventional wisdom dies hard or at least is outperformed. Technological innovations in unconventional shale plays and renewables are concurrent within a singularly defined energy policy. Surveying a matrix of valuation drivers against perceptions in today’s capital market environment sets forth new parameters of decision making, marking points of inflection on near- and intermediate-term charts.
An oversaturation of proprietary third party research in a mainstream investment sector such as Energy-Oil & Gas typically illuminates 'known knowns' while effectively supporting development of a lead/lag/input/output/industrial/consumer matrix time-laddered investment strategy. For instance, deconstructing FRAK and evaluating its component members enables determination of a lower bound price for WTI of $40 (breakeven production) plus parameters of capital market expectations for returns $42.60 (debt @ 6.5%) and $45 (equity @ 12.5%) based on corporate and resource profiles to match anticipated interim price targets of $50-$60-$70 per barrel. The demand-side of the equation is continuously tested, as growth drivers again become risk factors, by incorporating scenario/sensitivity analysis in financial models per company per basin per well. This equity strategy returned 23.5% - 47.4% among FRAK Top 10 performers YTD (051515) during a period when companies realized cost efficiencies and maximized performance along an improving price curve across oil and gas fields throughout North America (Bakken, Permian, Eagle Ford, Marcellus, the Rockies, California, Oklahoma, Michigan, Illinois, Louisiana and Canada).
Conversely, an undercovered and underserved investment universe necessitates removal of structured constraints to exploit generalizations against convention. To illustrate, possibly as a matter of expediency two of the leading major third party data vendors assign solar companies to comparatively generic Industry/Subindustry designations such as Renewable Energy/Renewable Energy Equipment or Semiconductors/Solar. In this manner queried results skew peer group analytics and valuation unable to adequately distinguish specific business segment operations. Independent study suggests relative value assessments within solar segment verticals are attainable based on refined subindustry nomenclature assignments via applied indexation and capital markets metrics derived from the variance of proportionate component member market capitalization relative to portfolio weight per segment per classification. Utilizing this methodology, specific solar segment classification verticals (Integrated, Plants, Modules and YieldCo) captured 50% of cross-referenced TAN US-listed Top 10 performers YTD (051515) with ranged returns of 27.2% - 104.6% from data computations published during the two previous sequential reporting periods (1Q15 and 4Q14).
Not lost in performance figures are the spread differentials among asset class capitalizations and implied effects on performance attribution. Consider JKF - iShares Morningstar Large-Cap Value ETF, JKE - iShares Morningstar Large-Cap Growth ETF, JKH - iShares Morningstar Mid-Cap Growth ETF and JKK - iShares Morningstar Small-Cap Growth ETF:
Together with the causality determined by regression analysis, supply and demand characteristics exhibited within the Energy sector establish quantifiable relative value assessments based on capital markets metrics and refined nomenclature:
Evident in the table above, the subset of FRAK/TAN/FAN is relatively weakly correlated although significantly outperforms component members of the one energy equation. Interestingly, higher levels of correlation within the one energy equation (absent UNG as marginal price arbiter) are more indicative of Beta boosters than Alpha drivers. The statistical relevance of Mid-Cap Growth (capitalization performance leader YTD 051515) cannot be overstated given previously-sized Small-Cap Growth companies reinforced market niche penetration, matured and developed into industry leaders in the current mid- to late-cycle US economy. Finally, the ongoing Value versus Growth discussion persists in two strongly correlated subsets: 1) XLE/FRAK/JKF (Large-Cap Value) representing a capital intensive industry and volatile commodity price environment and 2) PBW/TAN/JKK (Small-Cap Growth) representing scaled implementation of emerging technologies and acceptance of broader public policy implications.
Beyond abstraction, publicly sourced and policy delineated government whitepapers serve in support to test the investment premise of a one energy equation. A recent presidential decree quelled the perceived ambiguity of climate change, associated statistical vagaries and contentious debate. For proposition, if Energy policy remains constant then the variability of capital market performance among its component members is consistent with the demand drivers per policy . . . albeit somewhat geocentric.